How to invest in emerging markets

Most new investors, and plenty of more experienced ones too, like to stick to what and where they know when it comes to investing their hard-earned cash in equities. For many people, that means investing only in the UK stockmarket.

On the face of it, this makes a lot of sense. Britain has a long-established, stable, and well-regulated stockmarket which has performed reasonably well over the long run. It's easy to invest in UK stocks, and there's much to be said for the peace of mind that comes from keeping your money close to home.

Traditionally, the vast bulk of UK investors have done just that. Those who wanted a bit more adventure have tended to diversify, through pooled funds, into other advanced economies such as the United States, Western Europe or (until its long slump) Japan. When these markets were doing nicely, all was well.

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But in recent years, this kind of safety-first strategy has not led to the big returns of the 1980s and 1990s. Instead, over the past few years, the star performers among global markets have been in the "emerging markets" of Latin America, ex-Communist states in eastern Europe, Russia, and even Africa.

What is an emerging market?

The International Finance Corporation of the World Bank, who coined the term in 1981, define an emerging market as any economy where the per capita gross national product is less than $9,385 a year. In this sense, it's just a polite or aspirational term for any poor country, and covers around 80% of the global population, including the world's great economic powerhouse, China. However, for investors, an emerging market generally means a low-to-middle income nation which is pursuing substantial economic and political reforms and thus becoming more integrated into the global economy.

An emerging market might have an underdeveloped or developing commercial and financial infrastructure, and a recent history of rescheduling or even defaulting on sovereign debt. But it should also have a recent record of economic liberalisation, functioning equity and debt markets, and significant potential for both economic growth and capital market investment by foreigners. In short, an emerging market is a poor country that might be worth investing in. Classic examples include Argentina, Brazil, Mexico, India and Russia.

Aren't emerging markets risky?

Yes. In the worst-case scenario, an emerging market might plunge back into political chaos or civil disorder, sparking a change in government and a swing back to nationalisation, expropriation of foreigners' money and the collapse of the capital markets.

Even in less dramatic circumstances, investments in emerging markets are more vulnerable to everything from exchange-rate fluctuations to speculative panics like the Asian crisis of 1997. But all of these risks come with the territory. Adding risk to your portfolio and chasing higher returns is the whole point of investing in emerging markets. Potentially, the rewards can be spectacular.

How have they performed?

Using figures from Morgan Stanley (available at www.MSCI.com) we can compare the overall performance of the UK stockmarket with that of emerging markets over the past ten years. This period has seen huge volatility in the markets the late-1990s surge, followed by a crash in 2000-03 and the healthy bounce back. Re-basing in US dollars for the purposes of comparison, the UK stockmarket has delivered annualised returns averaging 6.3% over the ten-year period.

This figure overstates the return to UK investors who invested their money at home in pounds sterling, the return was just 4.6%. In dollar terms, the return from all emerging markets was 5.1% (rather more in local currencies). This suggests that over the long run (ten years, say), UK investors would have done marginally better to invest in the domestic market than emerging markets. However, owing to the volatility of up-and-coming markets this doesn't show the whole picture.

How have they done recently?

When we look at just the past five years, a very different picture emerges. During this period of slump and recovery, the UK stockmarket has grown by an annual average of 5.3% in dollar terms, and a miserly 1% in pounds sterling. In other words, Brits would have done far better to keep their money in a bank. By contrast, emerging markets have boomed, growing 21.4% every year.

Over three years, the UK is up 20.2% a year, and emerging markets 40.5%. In the past year, the UK is up a healthy 14.4%, but emerging markets are up an astonishing 52.3% with Latin America and Eastern Europe leading the way. All of this explains the surge of interest in emerging markets investment, and suggests that UK investors would be wise to consider putting at least a small proportion of their money into these markets.

How do I invest?

Happily, most of the big name retail investment houses offer general emerging markets funds which give easy and reasonably cheap access to global equities. To research these funds visit www.citywire.co.uk/funds where you can easily compare the performance of funds in any sector (in this case, Global Emerging Markets) over periods from three months to ten years.

Each of these funds will have a different geographical bias, so be sure to check carefully what you are investing in. Or, if you decide you would prefer to put your emerging markets money mainly in Latin America, or mainly in Eastern Europe, there is a choice of UK-based funds that will let you do that too.